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Appeal of Shared National Credit (Third Quarter 2014)

Background

A participant bank appealed the nonaccrual accounting treatment assigned to an asset-based lending (ABL) facility during the 2014 Shared National Credit (SNC) examination.

Discussion

The appeal stated that accrual of interest income was appropriate for the facility because the facility was well secured and full collection of principal and interest was not in question. The appeal asserted that the facility is a traditional ABL with adequate collateral controls including full cash dominion, a liquidity triggering event, annual inventory appraisals, and field examinations. Additionally, the lenders have reasonable discretion to implement reserves or change the borrowing base structure in the event of deterioration of the credit.

The appeal asserted that the collateral for the facility is a first lien on the borrower’s working capital assets and a second lien on all other assets. The borrowing base is supported by an 85 percent advance rate on eligible receivables and Net Orderly Liquidation Value of the inventory. The bank notes that 71 percent of the inventory is finished and, in the event of a liquidation, the likely scenario is that current customers will take the finished goods. In addition, the SNC loan write-up views the ABL facility as adequately collateralized as of March 31, 2014.

The appeal stated that all payments are current and the ABL is well secured by liquid receivables and inventory. The inventory had a current appraisal, liquidation values have been consistent, and collateral coverage is 1.2 times, which equates to a collateral cushion of $21 million. The current plan under consideration is for the company to merge with a competitor, and if that plan fails, to enter a bankruptcy filing. The appeal stated that in a bankruptcy situation, the ABL facility could be rolled into a debtor-in-possession ABL, and with the sale or liquidation of the company, the bank expects payment in full due to the well-secured nature of the facility.

The appeal also stated that repayment capacity should be determined by analyzing conversion of working capital assets into cash, rather than the SNC examination team’s significant reliance on earnings before interest, tax, depreciation, and amortization expense (EBITDA) to pay fixed charges and the borrower accessing availability from revolving credit facilities to cover cash flow shortfalls. Further, the appeal stated that evaluating asset-based credits on factors other than the borrowing base liquidity and liquid collateral values could negatively affect similar situated companies’ access to credit. The appeal requested consideration of the policy whereby conventional asset-based credits may be rated from a cash flow perspective.

Conclusion

An interagency appeals panel of three senior credit examiners determined that cash basis nonaccrual treatment was appropriate because the assets supporting this credit are deemed fully collectible. Interest income received may be recorded as income on a cash basis.

The appeals panel acknowledged that the transaction structure is satisfactory, with the ABL having a priority ranking in the capital structure ahead of other first lien secured debt. Collateral controls are in place, and the lenders have discretion in the event of deterioration of the credit. The depth of the borrower’s financial issues, however, could have a negative impact on repayment capacity. Concerns include strained liquidity resulting from a substantial reduction of cash, diminished availability under the ABL and cash flow revolver, significant operating losses, and negative cash flow in a declining industry. Additionally, the company is operating with high leverage and weak performance to plan. During 2013 and the first quarter of 2014, operating performance further deteriorated. Cash balances have declined over the past two years, and ABL usage has increased from $54 million at the SNC examination in 2013 to $100 million at the current examination. Excess ABL funds are currently being used to cover cash flow shortfalls including debt service.

The appeals panel acknowledged that the ABL facility is current and collateral coverage is sufficient. Successful completion of the potential merger, however, is questionable and the transaction is subject to anti-trust clearance by regulators. If the company enters bankruptcy because of continued deteriorating financial condition, there will be considerable uncertainty regarding future debt repayment.

Regarding the rating analysis for the ABL facility, the appeals panel concurred with the SNC examination team to analyze the facility using a cash flow perspective. The company has sustained significant net losses in a declining industry, is highly leveraged, has deteriorating liquidity, and has a reduced borrowing base availability. Free cash flow has been negative since 2010 and is projected to remain so through 2020. Cash balances are declining, and liquidity is strained. The company’s high leverage and resulting interest expense have materially contributed to the use of available liquidity, including the ABL, to pay fixed charges to service debt. Further, the company is attempting to merge, which if unsuccessful would likely lead to bankruptcy. These factors, particularly the company’s weak liquidity position, have limited its financial flexibility and support the decision to perform risk rating analysis for this facility on a cash flow basis.

Finally, the deteriorating financial condition has a significant and ongoing impact on the company’s operations. The fact that the assets supporting this ABL are sufficient to provide repayment of principal at the time of the review does not negate the weaknesses in and concerns associated with the borrower’s inability to generate cash flow. Although the policy implications described above have been considered, accurate risk rating of individual credits is a key objective of the SNC examination and subsequent review conducted by the appeals panel.